Queensland Power Conference
The Heritage, Brisbane
27 May 1999
Regulating Networks
Michael Rawstron
Senior Assistant Commissioner – Electricity
Australian Competition and Consumer Commission
Regulating Networks
1. Introduction
The topic I have been asked to address today is “Regulating Networks.” In my presentation, I will first explain the background to the transmission network access regime that has been introduced in Australia. Second, I will provide an overview of the various network access frameworks that have been adopted. Third, I will discuss the regulatory approach that the Australian Competition and Consumer Commission (ACCC) is adopting as it prepares for its role incentive regulating transmission network revenues in the National Electricity Market (NEM). Next, I will briefly discuss the ACCC’s draft decision on the revenue cap for New South Wales and Australian Capital Territory electricity transmission services. Following this, I will outline principles of best practice regulation that have been adopted by the ACCC. Finally, I will discuss a number of emerging issues that may impinge on the ability of the ACCC to effectively regulate transmission network revenues in the NEM.
2. Background to access regulation
While the generation and retail sectors are progressively being opened up to competition in Australia, the electricity network required to transport electricity from generators to end users (whether transmission or distribution systems) are natural monopolies. In these markets, there exists an imbalance of the relative bargaining position of network service providers (NSPs) and consumers of the service. Consequently, prices can be distorted above economically efficient levels with a resultant adverse impact on economic efficiency and community well being.
There was an acceptance in the development of the NEM that networks play a significant part in encouraging upstream and downstream competition. It is recognised that access to the services provided by the monopoly transmission and distribution NSPs is essential for entry into the generation and retail sectors.
The need for access to the services of natural monopoly providers in order to boost upstream and downstream competition has been recognised in other nations, notably the United States, for decades. Indeed, as far back as 1912, the United States courts were imposing a requirement on the owners of bottleneck facilities to grant access on reasonable and non-discriminatory terms in order to promote competition in related markets.[1]
In Australia, a legal framework to establish access rights to services provided by nationally significant infrastructure facilities was established with the introduction of Part IIIA of the Trade Practices Act (TPA) in 1995. Part IIIA is based on the notion that competition and efficiency are increased by overriding the ability of owners of monopoly facilities to determine the terms and conditions on which they will grant access to the services of their facilities. The focus in Part IIIA is upon access to facilities of national importance, in order to promote competition in an upstream or downstream market. Part IIIA establishes three approaches to third party access.
1. The first is by having a particular service declared as that of an essential facility, such that disputes over the terms and conditions of access not resolved through commercial negotiations can be subjected to compulsory arbitration by the ACCC.
2. The second is through having an existing State-based access regime recognised as effective by the designated Federal Minister.
3. The third enables the owner of an essential facility to enter into an access undertaking with the ACCC setting out the terms and conditions on which third parties will be provided with access to the services of the facility.
The electricity supply industry (ESI) in Australia followed this latter route, with the National Electricity Code Administrator (NECA) submitting to the ACCC an application for an access code for electricity related services provided by transmission and distribution facilities in the NEM.
3. Network access regulation frameworks
There are a number of different options of dealing with network access issues that have been adopted around the world.
3.1 No regulation
The regulatory approach that has been adopted in New Zealand for much of the past decade would most accurately be described as a ‘no regulation’ approach. This approach, notably adopted in electricity and telecommunications, is based on the notion that network service providers and network users are best placed to look after their own interests provided they have legal mechanisms to enforce rights of access.
In New Zealand, there has been no counterpart to Part IIIA, with the result that interested parties have been required to negotiate access. If satisfactory access terms are not reached, parties have had to seek redress through the courts relying upon section 36 of the New Zealand Commerce Act, which deals with abuse of a dominant position.
The other element of this regulatory approach involves information disclosure. By allowing comparisons of the prices and performance between different power companies, this information disclosure is intended to discourage monopoly pricing, excessive cross subsidisation and promote competition by facilitating access.
However, this approach has proven somewhat problematic, with the long running Clear Communications case showing that the ‘no regulation’ approach does not provide easy answers to access problems.[2] Indeed, there has been a rethinking of this regulatory approach. It was recently reported that the New Zealand Government is turning the existing guidelines that govern profits NSPs can make into strictly enforced price controls.[3]
3.2 Negotiation / arbitration
Other models for access regulation include negotiation and arbitration. This is the default approach of Part IIIA of the TPA. In effect this approach requires access seekers to negotiate access with the owner of the facility. However, access seekers have recourse to arbitration, should access negotiations fail. Under this model, the regulator has the role of being arbitrator or appointing the arbitrator. There are elements of this regulatory framework in the current telecommunications arrangements.
3.3 Price regulation
Another approach is more direct, aimed at determining access prices or revenues. In the United States, this has been in the form of cost of service regulation. In exchange for servicing the needs of a particular region, the network owner recoups its cost of providing the transmission service. Of course this is also in the context of integrated utilities where transmission costs are rolled into a broader regulation of the rate base of the businesses, including the delivered price of energy to consumers.
There has been a degree of criticism of the cost of service approach, including that it creates incentives for firms to over invest in plant, inflate costs and cross subsidise. It has given rise to stranded cost issues as markets become deregulated. Furthermore, it is seen to be resource intensive for the regulator and regulated firm, and does not encourage the use of incentives to drive more efficient outcomes.
In any event whatever the approach taken there is a need for strong ring fencing of the network from any contestable or competitive activities of the business.
3.4 RPI – X incentive regulation
RPI – X price cap regulation, as an alternative to traditional rate of return regulation, developed as a practical regulatory tool in the early 1980s in Britain. Most notably, the newly privatised British Telecom (BT) was regulated by price caps after the recommendations of a 1983 report by Stephen Littlechild.
The standard RPI – X price cap involves the regulator setting a maximum price. This maximum price then rises in line with the main index of retail prices, the retail price index, but falls at a rate X set in advance by the regulator. The value of X is meant to reflect potential cost savings by the firm due to either increased efficiency or technological progress. The X factor enables these cost savings to be shared with consumers, without adversely affecting the incentives of the firm to minimise and achieve these savings, between review periods. The value of X and the absolute level of the price cap index are reviewed at set intervals. For example, the review period for BT was originally set at five years.
4. Network regulation in the Australian ESI
The regulatory approach that has been adopted in the Australian ESI most closely resembles the RPI – X regime in place in Britain.
The network pricing section of the National Electricity Code (Code) (chapter 6) proposes establishing uniform mechanisms for pricing access to networks whereby:
· the ACCC will determine asset values, rates of return and revenue caps for transmission networks; and
· The states and state regulators, such as IPART in New South Wales and the Office of the Regulator - General in Victoria, will determine asset values, rates of return, and asset caps for distribution networks.
The ACCC will assume responsibility for the regulation of transmission network revenues in the NEM on a progressive basis, commencing from 1 July 1999, when it assumes responsibility for the New South Wales transmission network service provider, TransGrid. The ACCC will oversee a transmission revenue regulatory regime using a revenue cap methodology based on CPI-X or some incentive based variant of CPI-X. The Code provides guiding principles on the operation of the revenue cap that the ACCC must take into account such as:
· an equitable allocation of efficiency gains between users and owners of the system;
· providing owners with a sustainable commercial revenue stream;
· prevention of monopoly rents;
· fostering efficient investment within the transmission sector and upstream and downstream of that sector;
· fostering the efficient use of existing infrastructure;
· promotion of competition in upstream and downstream markets;
· providing reasonable certainty and consistency over time of regulatory outcomes; and
· reasonable recognition of pre-existing government policies regarding transmission asset values, revenue paths and prices.
As national regulator for transmission, the ACCC is to be responsible for developing national guidelines and rules for application of those guidelines. The ACCC is currently producing the Principles for the Regulation of Transmission Revenues (Regulatory Principles) which will establish guidelines as to how it will exercise its power in this area. In effect, the Regulatory Principles will outline the principles by which the ACCC will regulate the industry. The Draft Regulatory Principles is being released today and is available from the ACCC’s Internet site: www.accc.gov.au.
In assuming its role as regulator of transmission revenue in the NEM, the ACCC’s aim is to adopt a regulatory process which eliminates monopoly pricing, provides a fair return to network owners, and creates incentives for managers to pursue ongoing efficiency gains through cost reductions. In achieving these aims the ACCC is aware of the need to ensure compliance costs are minimised and that the regulatory process is objective, transparent and as light handed as possible.
The transmission regulation framework outlined in the Draft Regulatory Principles is a building block approach based on forecasts of cost of service over the regulatory period. The building block approach calculates the AARR (Aggregate Annual Revenue Requirement) as the sum of the return on capital, the return of capital, and operating and maintenance expenditure, that is:
AARR = return on capital + return of capital + O&M
AARR = (WACC * WDV) + D + O&M
where WACC = weighted average cost of capital;
WDV = written down (depreciated) value of the asset base;
D = depreciation allowance; and
O&M = operating and maintenance expenditure (including administrative costs).
While the assessment of operating and maintenance expenditures is relatively straight forward, assessment of the other elements is not. Determining these elements of the accrual building block raises significant issues with respect to providing NSPs with a fair and reasonable return while at the same time promoting economic efficiency and an objective, transparent regulatory process.
It is therefore imperative that the regulator comes up with accurate revenue cap decisions. The ACCC implements the following procedures to ensure that this is the case. First, the ACCC conducts a transparent and open process in the determination of revenue caps for transmission NSPs. The ACCC invites stakeholders to put information forward to try to persuade the regulator and also consults with stakeholders to understand the implications of its regulatory decisions. Second, the ACCC attempts to gather the most accurate financial data it can in determining regulatory parameters.
4.1 Determining a fair rate of return on the asset base
In determining a rate of return, the NEC specifically requires the Commission to consider the weighted average cost of capital (WACC) for each transmission network. In the Draft Regulatory Principles, the Commission has adopted a nominal post-tax WACC approach. The WACC is the weighted average of the cost of equity and the cost of debt, each cost weighted by its proportion in the company’s financial structure. The WACC is set on the basis of financial market benchmarks, taking into account the level of commercial risk involved in establishing the transmission infrastructure.
The WACC is a commonly used method for determining a return on an asset base. Its adoption, along with the building block approach, was strongly endorsed in submissions received in response to the Regulation of Transmission Revenues Issues Paper released in May 1998. The building block approach combines a rate of return with a regulatory asset value. Given the capital-intensive nature of electricity network businesses, the return on capital component of the regulated revenue could account for 50 per cent or more of annual aggregate revenue. As relatively small changes to the rate of return can have a significant impact on the total revenue requirement and ultimately end user prices, it is important that the regulator sets the rate of return at a level which reflects a commercial return for the regulated businesses. Setting a rate of return below the cost of funds in the market could make continued investment in developing the network difficult or unattractive for the owner. This would create pressure for the regulated business to reduce maintenance and capital expenditure below optimum levels and undermine the quality of service offered to users. Conversely if the rate of return were set too high by the regulator, the regulated businesses would earn a return in excess of their cost of capital. This would distort price signals to consumers and investors, resulting in a misallocation of resources and sub-optimal economic outcomes.